Aug 6, 2013

FASB Shakes Up Hedge Accounting Standards - OIS Rate Adopted as New Benchmark

While OIS has emerged as the proxy for the risk-free rate and continues to emerge as the new standard for collateral discounting in the OTC markets, the story continues to evolve. In late July the Financial Accounting Standards Board (FASB) announced its decision to adopt the OIS rate to the benchmarks recognized in its fair value accounting regime bringing to light how this shift might help eliminate potential hedge ineffectiveness.

In this video blog, Numerix experts reflect on FASB's decision - discussing potential implications for not only hedgers, but buy-side market participants, insurers and a those who haven't yet shifted to OIS.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript: FASB Shakes Up Hedge Accounting Standards - OIS Rate Adopted as New Benchmark

Jim Jockle (Host): Hi welcome to Numerix Video Blog, I am your host Jim Jockle. As the ongoing discussions around the standardizations and move towards OIS discounting continue to advance a major coup in standardization has just occurred. FASB, the financial accounting standards board has recognized the OIS rate as a hedge accounting benchmark. And with me today, to talk about this is Tom Davis, Ph. D. and Senior VP and Product Manager for Numerix CrossAsset. Welcome Tom how are you?

Tom Davis (Guest): Good thanks Jim. Thanks for having me.

Jockle: Well appreciate it. One of the key issues, a lot of lobbying has been going on in terms of getting the OIS rate to be identified, but the key question is, with this move how will this help in terms of eliminating potential hedge ineffectiveness? 

Davis: So the market has moved as we've seen as evidence by the clearing houses all using the overnight rates for the discounting for any cleared swap. And the markets really move for any cash collateralized derivative. And in terms of hedge effectiveness what this is, is the corporates who've projected future cash flows and future cash flows obligations - what they want to do is they want to buy a derivative in order to meet those so, you want to swap fix for floats for instance. And so these corporates buy derivatives. And the accounting regulations say your future obligations, you account for on an amortize basis however any derivative has to be accounted for on a fair market value. And that's subject to a lot of P&L fluctuations that adds a lot of volatility to their balance sheet that really lies outside of the core business operations.

So there's a regime and a set of rules set up by FASB, that allow for hedge effectiveness and if you can show that the derivative and the cash flows match. So what you're doing is really hedging those cash flows by the use of the derivative, then you don't have to account for the derivative in terms of P&L, you can do it on an amortize basis like your future obligations.
And so what we've seen is after the switch to OIS discounting in the market, the FASB hedge effectiveness rules did not allow for the discounting to be done at the overnight rate. It still had to be done at the LIBOR rate, but didn't really account for how the derivatives were funded, and there was a mismatch between the pricings, which gave a rise to a mismatch in the hedge effectiveness, making a lot of the derivatives have to go back on the balance sheet which was not very palatable to a lot of these corporates.

And so what has happened is there's been a lot of lobbying and on November 17th there was a letter presented to FASB, a joint letter from ISDA and SIFMA, lobbying for the OIS to be introduced as the discounting rate. And it has.
And so FASB has just announced this week that the official benchmark rate for discounting cash collateralized derivatives is the OIS rate, reflecting what the market practice and what the market consensus is. So that's going to increase, and get back in line with hedge effectiveness tasks for a lot of the derivatives and corporates hold to hedge their future obligations.

Jockle: Now not everybody has moved to an OIS discounting, as we know and we continue to hear about some of the challenges insurers are having in this space. So what is the timelines and what happens to those who haven't fully implemented this type of regime in their institution?

Davis: Well for the market data, if you go to the market and you strip your forward curve and you strip your discounting curves, you're going to be using this implicitly anyway. Because all of the quotes from the swaps you see in the swaptions, are going to incorporate this two curve approach, or this different discounting. So in some sense, a lot of the market data that you're going to be using and consuming, already have this in place.

There's a couple of things where there's still going to be some mismatch between what the market is doing and what you're going to be doing in house. For instance the one thing in the FASB ruling that I want to point out, is that they have not identified the Fed Fund rate as a source of interest rate exposure. So it's still limited to the LIBOR rate and the treasury rate, and so if your future obligations have any explicit exposure to the Fed Funds, then you're not even going to be able to put that into your hedge accounting program. The story is still evolving and that's another thing that the risk consultants are saying. This has to be another step forward. It's still an open question, and the story is still evolving in that sense.

Jockle: And we've seen many reports at this point in time in where there was a market opportunity between those who've adopted a dual curve approach versus those who've had it, is this a signal to the end that the arbitrage opportunity around this is gone?

Davis: That's a good question. In terms of a signal in the market place, it is a big signal. I mean what we're seeing now is that this is this board that is out to protect in some sense the buy side, who's not as savvy as sell side in a lot of instances. So this market announcement that FASB and the accounting bodies have adopted this, I think is a big signal that this is not just a flash in the pan. This is here to stay. This overnight discounting is very well understood now by the markets, and it's based on and has compelled to us by cash collateralization and you fund your derivative through the cash rate.

Of course there's the other point of view that says LIBOR is not risk free it has credit risk embedded in it, and so therefore the OIS rate is the overnight rate, is the closest proxy to the risk free rate. You see now that the accounting boards have stepped in and said okay we're using OIS, I think that does signal that OIS is really prevalent and should be adopted whole scale for cash collateralized derivatives in the market place.

Jockle: Well Tom thank you so much on the insights and it looks like one chapter is closing but another chapter as it relates to the FVA debate is going to be much more top of mind. And Tom, I look forward to getting into that a little bit more with you. I know we've talked about it in the past. We want to hear about what you think. Please join the conversation on twitter @nxanalytics or on our blog. We want to hear your feedback and want to make sure we're talking about the things that you want to talk about. Tom thank you very much, and we'll see you next time.

Davis: Thanks Jim.  




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